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UK equities

Initial reaction: Brexit, or the world’s first “DIY recession”

The UK has voted to leave the European Union. As the initial reaction in financial markets has shown, there is no merit in pretending that for investors and companies this is not, by some margin, the worst of the two possible outcomes of the referendum.

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Has there ever been a fall from grace as dramatic as that of Theresa May and the Conservative Party?

When, on 18 April, the prime minister called a snap general election, the Conservatives enjoyed a 20 point opinion poll lead over the Labour Party. Much of the media predicted that the Tories would win a landslide victory, take seats in traditional Labour strongholds, and secure a triple digit majority in the House of Commons. Oh, how wrong we were!

Instead, May conducted possibly the worst election campaign in living memory, demonstrating a personal inability to connect with the electorate and scoring an own goal on the dementia tax. The result was one of the biggest reversals in political fortunes seen in modern British politics. If the campaign had run just a few weeks longer, Jeremy Corbyn and the Labour party might have formed the new government.

But what change, if any, has this situation made to the debate around the Brexit negotiations, and in particular to the aggressive tone taken by May and her cabinet before the election?

The result of the election has left the government in a perilous position. Even with the support of the Democratic Unionist Party, the Conservatives have a working majority of only 13* seats, affording increased influence to marginal factions within the party.

As highlighted over the weekend by Vince Cable (a former government minister and the likely next leader of the Liberal Democrats), divisions within both major UK parties, and the sheer complexity of the negotiation process, may mean that Brexit never happens.

Business heard again

Whatever the truth of that, politicians were deaf to UK business during the referendum campaign; now, business voices are not only heard but emboldened by the political vacuum to press their case.

The economy and jobs are rising rapidly up the agenda and have become key UK objectives in the Brexit negotiations. ‘No one voted to be poorer!’ is a mantra increasingly voiced. The UK may still be on track to leave the EU, but it seems increasingly likely to us that access to the single market and membership of the customs union will be sought under a transitional arrangement until a full and comprehensive trade deal is completed between the UK and the EU. Indeed this was exactly the proposal made last week by CBI head Carolyn Fairbairn.

Although apparently a sensible strategy, given how long trade negotiations often take (between five and seven years), a transitional arrangement could kick the final deal a long way down the road. Tina Fordham, a political analyst at Citibank, has suggested that given the complexity of the Brexit negotiations, the divisions within the two major parties, and the possibility that the negotiations may drag on for years after the March 2019 article 50 deadline, Brexit may be permanently delayed. After all, by then we may be into a fresh political cycle.

Sterling rallies

What does this all mean for UK currency and fixed income markets? The best barometer for ‘hard’ or ‘soft’ Brexit for the last 12 months has been sterling. The debate about what type of Brexit will now be negotiated has seen sterling recently rally towards a nine month high. A further watering down of a hard exit from the EU and the possibility of retaining some access to the single market could cause a further rally in the currency.

But what about UK interest rates? There have recently been some more hawkish comments from individual members of the Bank of England’s monetary policy committee, including governor Mark Carney, who has suggested that tolerance for faster inflation is “limited”. However, despite a split vote on rates in the latest committee meeting, with three members voting for a rate rise, it is still difficult, given the current political and economic uncertainty, to see the Bank of England raising rates anytime soon. Real incomes remain under pressure; and the rise in inflation is not demand- or wage-led but largely an effect of the sharp depreciation of sterling after the referendum vote on 23 June 2016.

Longer term UK interest rates could experience upward pressure due to the higher inflation prints likely, in our view, to be seen over the next 12 months, and as the political weakness of the current government forces ministers to loosen the fiscal reins. There have already been calls to relax the UK public sector pay cap.

All in all, UK politics and economics has one of the most interesting and unpredictable futures in the developed world. Fasten your seatbelts, this could be a bumpy ride!

*assuming that Anne Marie Morris, the MP for Newton Abbott, from whom the Tory whip was withdrawn on 10 July, continues to vote with the government.

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The opportunity set, both on the long and short side, is as compelling as it has ever been, explains Tim Service, manager of the Old Mutual UK Specialist Equity Fund.